The current situation is a good-news-bad-news scenario, with the bad news being more pressing, and requiring immediate attention. Here is how I would characterise the state of play with respect to central government finances. The last government certainly had laudable goals, and sought to make the fruits of growth available to the bottom of the pyramid. But it promised more than it could deliver. Having increased subsidy commitments, it had resorted to rolling over subsidies to keep the official fiscal deficit from exceeding prudent guidelines. But this was just postponing the problem, and sometimes making it worse in the future. Furthermore, unable to pass legislation to introduce the goods and services tax (GST), and faced with anaemic revenues as growth slowed down (due to a combination of policy paralysis, global uncertainties and domestic roadblocks), it resorted to stratagems such as retrospective taxation, new minimum taxes and so on, which only created more worry for investors and further slowed growth. This is the bad news that the new government has inherited.
If this is a honeymoon period, then this is the time for the government to fix what it can right away. Rolling over subsidies is not an approach that should be continued, and the government should begin the task of cutting these subsidies in earnest. Also on the expenditure side, the central governments fondness for planning and for various national missions has led to a somewhat chaotic allocation of funding across agencies, sectors and levels of government. This is the time to go for a drastic simplification, abandoning central planning as a mechanism for controlling flows of funds, and letting central ministries make allocations for expenditures that are central government responsibilities, or categorical grants to the states if they wish. This is also a good time for the central government to pull back from discretionary transfers for expenditures that are state responsibilities according to the Constitution, and give the 14th Finance Commission more room to make tax-sharing allocations (essentially non-categorical block grants) to the states.
On the revenue side, the GST will take time to introduce. In the meantime, the central government needs to broaden the base for direct taxes. It is imperative that the exemption limit for personal income tax not be raised. Citizens need to feel that they are paying for the government as well as benefiting from it, and income taxes are a good way to create that connection. It is true that inflation increases the tax burden, pushing people into taxable brackets as their income grows in nominal but not real terms, but even if this is the case, it can be dealt with by slightly lower tax rates. The number of income-tax payers in India is already very small, and raising the exemption limit is an unnecessary populist measure. Keeping taxation simple and broad-based is an easy first step towards revenue buoyancy. If the government wants to encourage growth more actively, then it should look into more generous investment tax credits, or tax incentives for innovation and risk-taking. Aside from taxes, an important source of revenue (even if one-time) has to be a more robust public sector disinvestment programme.
What is the good news Simply put, there are so many growth-promoting policies that the government can introduce, that it has an embarrassment of riches on this front. Policy changes that have little or no direct budgetary impact can have huge political costs, of course. But the new government has the political capital to spend. It was voted in to get Indias economy back on to a higher growth path. Recently, Prof Arvind Panagariya in India Today has provided a comprehensive account of possible policy reforms, including those that bring the Budget into safer territory, but also those that will remove inefficiencies and obstacles to growth. These include not just liberalisation-type reforms, but also improvements in the working of government so that it performs its core functions better.
The economics of what needs to be in the new governments Budget are clear: a better balance of revenue and expenditure, and more efficient mechanisms for spending and taxing. The momentous nature of the general election result means that the government also has a clear political mandate, which it has to pursue, despite possible interest-group pressures, or bureaucratic risk aversion. One is waiting for this Budget with anticipation and a great deal of hope.
The author is professor of Economics, University of California, Santa Cruz